Abstract
Recent financial crises were the root of many changes in regulatory implementations in the banking sector. Basel previously covered the default capital charge for counterparty exposures however, the crisis showed that more than two third of the losses related to this risk emerged from the exposure to the movement of the counterparty’s credit quality and not its actual default therefore, Basel III divided the required counterparty risk capital into two categories: The traditional default capital charge and an additional counter-party credit valuation adjustment (CVA) capital charge. In this article, we explain the new methodologies to compute these capital charges on the OTC market: The standardized approach for default capital charge (SA-CCR) and the basic approach for CVA (BA-CVA). Based on historical calibration and future estimations, we built internal models in order to compare them with the amended standardized approach. Up till June 2015, interest rate and FX derivatives constituted more than 90% of the traded total OTC notional amount; we constructed our application on such portfolios containing and computed their total counterparty capital charge. The analysis reflected different impacts of the netting and collateral agreements on the regulatory capital depending on the instruments’ typologies. Moreover, results showed an important increase in the capital charge due to the CVA addition doubling it in some cases.
Highlights
Derivatives market witnessed an important bloom in recent decades due to their increasing utility in our financial markets
We note that this might be due to the assumptions taken on the standardized approach for default capital charge (SA-counterparty credit risk (CCR)) level assuming a 15% volatility factor whereas the GARCH approach begins by assuming lower observed volatilities on the stressed period this explains the difference in behaviors depending on the maturities
This work permits comparison between the standardized approaches used by Basel and suggests internal model methodology based on historical and futuristic observations through various applications on simple portfolios
Summary
Derivatives market witnessed an important bloom in recent decades due to their increasing utility in our financial markets. Recent crises emphasized the faulty practices regarding the OTC derivatives capital charge computation from a counterparty credit risk point of view: Starting with the collapse of Lehman Brothers and several near and full collapses of banks all over the United States, United Kingdom and Europe, the counterparty risk gained the same importance as the major well-known risks (market, liquidity, operational...). Counterparty credit risk has gained importance making it a central need in several areas of the banking workflow: Pricing OTC products, computing the capital charges, managing exposures to different counterparties and stating the conditions of a certain deal concerning the initial margin or collateral. In this paper our aim is to describe the current OTC market, to briefly note the previously applied regulatory methods for the counterparty credit risk to explain and apply the new methods in order to compute the capital requirements on typical portfolios.
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